The Supreme Court yesterday issued its decision in Morrison v. National Australia Bank, its first ever on the international reach of Section 10(b) and Rule 10b-5. Justice Scalia wrote for the Court, with additional opinions by Justice Breyer (concurring in part and concurring in the judgment) and Justice Stevens, joined by Justice Ginsberg (concurring in the judgment). Justice Sotomayor did not participate.

The federal securities laws in general, and the Securities Exchange Act in particular, say nothing about the international reach of the fraud provisions. Beginning in the 1960s, the lower federal courts developed an elaborate jurisprudence aimed at clarifying how far the reach extended. That jurisprudence – largely the creation of the renowned Judge Henry J. Friendly of the Second Circuit – proceeded from the assumption that back in the 1930s, Congress did not anticipate the eventual internationalization of the securities markets. Seeking to ascertain what Congress would have done if it had actually addressed the question, Judge Friendly and others formulated what came to be known as the “conduct” test and the “effects” test. Under the conduct test, a federal district court had subject matter jurisdiction if the bulk of the fraudulent conduct occurred in the US, even if the effects were felt largely, if not entirely, by investors outside the US. The most often-mentioned rationale for this test was that Congress would not have wanted the US to serve as a “launching pad” for fraud that did harm elsewhere. Under the effects test, jurisdiction attached when conduct, even if it occurred in other countries, produced immediate and substantial effects on US investors or US markets. The rationale for this test, not surprisingly, was that US investors and US markets had been Congress’s primary concern. While Judge Friendly and others recognized the possibility that other countries might object to assertions of jurisdiction by the US, they regarded the risk as minimal because, in their estimation, all countries were of one mind about fraud.

Morrison itself was a so-called “foreign cubed” case, that is, one brought by foreign plaintiffs who bought or sold foreign shares on a foreign exchange. The plaintiffs, citizens of Australia, had purchased shares of an Australian bank on the Australian Securities Exchange. They nonetheless filed a fraud-on-the market action in the Southern District of New York, which, they claimed, had jurisdiction to hear the case because the fraud at issue had been concocted in Florida, the location of the bank’s wholly-owned US subsidiary. Florida was the place where the subsidiary allegedly cooked its books and from which it then sent falsified figures to the bank’s headquarters in Australia. Headquarters then incorporated those figures without change into filings made with the Australian Securities Exchange as well as with other exchanges, including the New York Stock Exchange (where the bank’s American Depository Receipts were traded). There were no American plaintiffs in Morrison, with the exception of one whose claim was dismissed early on because of his failure to plead damages. He was not a part of the appeal.

The SDNY dismissed the case for lack of jurisdiction. Labeling the dismissal a “close call,” the court reasoned that there would have been no securities fraud at all without the act of incorporation that occurred in Australia. Thus, in the district court’s view, the critical conduct had occurred in Australia, not in the US. The Second Circuit affirmed on essentially similar grounds, without the trial court’s seeming hesitancy. The Second Circuit, however, expressly declined to bar all foreign cubed claims.

The Supreme Court affirmed the Second Circuit’s decision for reasons that were altogether alien to that court’s jurisprudence. Justice Scalia’s highly critical opinion began by observing that the Second Circuit had made a forty-year-long blunder in characterizing Rule 10b-5's extraterritorial reach as jurisdictional, when in fact it pertained to the merits. (The parties did not dispute the merits characterization, but they had not briefed it.) A remand was nonetheless inappropriate, Justice Scalia explained, because this “threshold error” had not been integral to the reasoning of the courts below.

Justice Scalia went on to excoriate the Second Circuit for constructing a jurisprudence that ignored the presumption against extraterritoriality. In addition, he belittled the conduct test and the effects test for their lack of a statutory anchor as well as for the difficulties inherent in applying them. (Going even farther, he noted with approval an article that I wrote twenty years ago challenging the notion that the 1930s Congress lacked awareness of internationalized securities markets.) Finding no statutory basis for applying Section 10(b) extraterritorially, he concluded that the Section did not so apply.

But he could not leave matters there, because numerous cases are neither wholly foreign nor wholly domestic. Focusing on Section 10(b), he noted that the Section forbids not all deceptive conduct, but only deceptive conduct “‘in connection with the purchase or sale of any security registered on a national securities exchange or on any security not so registered.’” Finding the statutory focus to be the “purchase and sale transactions,” he concluded that Section 10(b) applied to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” He asserted that this “transactional test” provides the clarity that the conduct test and the effects test lacked.

A few observations about this remarkable opinion:

The opinion makes no mention of the loss of investor protection that will result from the switch to the transaction test. For example, it leaves unprotected US citizens who purchase or sell securities outside the United States. Likewise unprotected are foreign citizens trading abroad who are victims of domestic conduct perpetrated by Americans over whom the foreign forum lacks personal jurisdiction.

Why not allow these investors to sue in United States courts? One reason is the abandonment of the idea that all countries are of one mind about fraud. As Justice Scalia noted, “the regulation of other countries often differs from ours as to what constitutes fraud, what disclosures must be made, what damages are recoverable, what discovery is available in litigation, what individual actions may be joined in a single suit, what attorney’s fees are recoverable, and many other matters.” In making these observations, he drew on amicus briefs by foreign countries that wish to exert exclusive control over the prosecution of securities trades occurring within their own borders. While Justice Scalia does not say so expressly, accommodating these countries in this regard may help to promote globalized securities markets.

Justice Scalia maintained that the new “transactional test” will give the foreign amici the certainty that they crave. Will it really do so? Sometimes. Most likely it is the second prong – “domestic transactions in other securities” – that will produce trouble. Suppose a foreign brokerage firm has a US affiliate. If the foreign brokerage firm receives an order to trade from a foreign investor and executes the trade in the US through the US affiliate, does the trade qualify as a domestic transaction? Moreover, suppose a US investor purchases a foreign security, not traded on a US exchange, from the comfort of his living room through the auspices of an interactive web site maintained outside the United States. Can that qualify as a domestic transaction?

There is a real question about where the opinion leaves actions brought by SEC and the DOJ. While Justice Stevens’s concurrence suggests that it leaves them untouched, this conclusion seems questionable. The Court’s reasoning focused on the presumption of extraterritoriality and the text of Section 10(b), both of which apply as much to the government as they do to private parties.

To be sure, the question regarding the impact on the SEC and the DOJ will evaporate in the event that Section 7216 of H.R. 4173 becomes law. That Section (which has passed the House and is currently in a House/Senate Conference Committee) articulates a broad extraterritorial reach for fraud actions brought by the SEC and the DOJ. The Section also makes that reach expressly jurisdictional. As a result, it would override Morrison’s “threshold error,”at least so far as SEC and DOJ actions are concerned.

In its present iteration, Section 7216 is silent about extraterritoriality as it pertains to private fraud actions. The need to square that silence with Morrison may be just around the corner.

PS Early this morning, the Conference Committee came to an agreement. The text of their bill is not yet available.

The Supreme Court yesterday issued its decision in Morrison v. National Australia Bank, its first ever on the international reach of Section 10(b) and Rule 10b-5. Justice Scalia wrote for the Court, with additional opinions by Justice Breyer (concurring in part and concurring in the judgment) and Justice Stevens, joined by Justice Ginsberg (concurring in the judgment). Justice Sotomayor did not participate.

The federal securities laws in general, and the Securities Exchange Act in particular, say nothing about the international reach of the fraud provisions. Beginning in the 1960s, the lower federal courts developed an elaborate jurisprudence aimed at clarifying how far the reach extended. That jurisprudence – largely the creation of the renowned Judge Henry J. Friendly of the Second Circuit – proceeded from the assumption that back in the 1930s, Congress did not anticipate the eventual internationalization of the securities markets. Seeking to ascertain what Congress would have done if it had actually addressed the question, Judge Friendly and others formulated what came to be known as the “conduct” test and the “effects” test. Under the conduct test, a federal district court had subject matter jurisdiction if the bulk of the fraudulent conduct occurred in the US, even if the effects were felt largely, if not entirely, by investors outside the US. The most often-mentioned rationale for this test was that Congress would not have wanted the US to serve as a “launching pad” for fraud that did harm elsewhere. Under the effects test, jurisdiction attached when conduct, even if it occurred in other countries, produced immediate and substantial effects on US investors or US markets. The rationale for this test, not surprisingly, was that US investors and US markets had been Congress’s primary concern. While Judge Friendly and others recognized the possibility that other countries might object to assertions of jurisdiction by the US, they regarded the risk as minimal because, in their estimation, all countries were of one mind about fraud.

Morrison itself was a so-called “foreign cubed” case, that is, one brought by foreign plaintiffs who bought or sold foreign shares on a foreign exchange. The plaintiffs, citizens of Australia, had purchased shares of an Australian bank on the Australian Securities Exchange. They nonetheless filed a fraud-on-the market action in the Southern District of New York, which, they claimed, had jurisdiction to hear the case because the fraud at issue had been concocted in Florida, the location of the bank’s wholly-owned US subsidiary. Florida was the place where the subsidiary allegedly cooked its books and from which it then sent falsified figures to the bank’s headquarters in Australia. Headquarters then incorporated those figures without change into filings made with the Australian Securities Exchange as well as with other exchanges, including the New York Stock Exchange (where the bank’s American Depository Receipts were traded). There were no American plaintiffs in Morrison, with the exception of one whose claim was dismissed early on because of his failure to plead damages. He was not a part of the appeal.

The SDNY dismissed the case for lack of jurisdiction. Labeling the dismissal a “close call,” the court reasoned that there would have been no securities fraud at all without the act of incorporation that occurred in Australia. Thus, in the district court’s view, the critical conduct had occurred in Australia, not in the US. The Second Circuit affirmed on essentially similar grounds, without the trial court’s seeming hesitancy. The Second Circuit, however, expressly declined to bar all foreign cubed claims.

The Supreme Court affirmed the Second Circuit’s decision for reasons that were altogether alien to that court’s jurisprudence. Justice Scalia’s highly critical opinion began by observing that the Second Circuit had made a forty-year-long blunder in characterizing Rule 10b-5's extraterritorial reach as jurisdictional, when in fact it pertained to the merits. (The parties did not dispute the merits characterization, but they had not briefed it.) A remand was nonetheless inappropriate, Justice Scalia explained, because this “threshold error” had not been integral to the reasoning of the courts below.

Justice Scalia went on to excoriate the Second Circuit for constructing a jurisprudence that ignored the presumption against extraterritoriality. In addition, he belittled the conduct test and the effects test for their lack of a statutory anchor as well as for the difficulties inherent in applying them. (Going even farther, he noted with approval an article that I wrote twenty years ago challenging the notion that the 1930s Congress lacked awareness of internationalized securities markets.) Finding no statutory basis for applying Section 10(b) extraterritorially, he concluded that the Section did not so apply.

But he could not leave matters there, because numerous cases are neither wholly foreign nor wholly domestic. Focusing on Section 10(b), he noted that the Section forbids not all deceptive conduct, but only deceptive conduct “‘in connection with the purchase or sale of any security registered on a national securities exchange or on any security not so registered.’” Finding the statutory focus to be the “purchase and sale transactions,” he concluded that Section 10(b) applied to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” He asserted that this “transactional test” provides the clarity that the conduct test and the effects test lacked.

A few observations about this remarkable opinion:

The opinion makes no mention of the loss of investor protection that will result from the switch to the transaction test. For example, it leaves unprotected US citizens who purchase or sell securities outside the United States. Likewise unprotected are foreign citizens trading abroad who are victims of domestic conduct perpetrated by Americans over whom the foreign forum lacks personal jurisdiction.

Why not allow these investors to sue in United States courts? One reason is the abandonment of the idea that all countries are of one mind about fraud. As Justice Scalia noted, “the regulation of other countries often differs from ours as to what constitutes fraud, what disclosures must be made, what damages are recoverable, what discovery is available in litigation, what individual actions may be joined in a single suit, what attorney’s fees are recoverable, and many other matters.” In making these observations, he drew on amicus briefs by foreign countries that wish to exert exclusive control over the prosecution of securities trades occurring within their own borders. While Justice Scalia does not say so expressly, accommodating these countries in this regard may help to promote globalized securities markets.

Justice Scalia maintained that the new “transactional test” will give the foreign amici the certainty that they crave. Will it really do so? Sometimes. Most likely it is the second prong – “domestic transactions in other securities” – that will produce trouble. Suppose a foreign brokerage firm has a US affiliate. If the foreign brokerage firm receives an order to trade from a foreign investor and executes the trade in the US through the US affiliate, does the trade qualify as a domestic transaction? Moreover, suppose a US investor purchases a foreign security, not traded on a US exchange, from the comfort of his living room through the auspices of an interactive web site maintained outside the United States. Can that qualify as a domestic transaction?

There is a real question about where the opinion leaves actions brought by SEC and the DOJ. While Justice Stevens’s concurrence suggests that it leaves them untouched, this conclusion seems questionable. The Court’s reasoning focused on the presumption of extraterritoriality and the text of Section 10(b), both of which apply as much to the government as they do to private parties.

To be sure, the question regarding the impact on the SEC and the DOJ will evaporate in the event that Section 7216 of H.R. 4173 becomes law. That Section (which has passed the House and is currently in a House/Senate Conference Committee) articulates a broad extraterritorial reach for fraud actions brought by the SEC and the DOJ. The Section also makes that reach expressly jurisdictional. As a result, it would override Morrison’s “threshold error,”at least so far as SEC and DOJ actions are concerned.

In its present iteration, Section 7216 is silent about extraterritoriality as it pertains to private fraud actions. The need to square that silence with Morrison may be just around the corner.

PS Early this morning, the Conference Committee came to an agreement. The text of their bill is not yet available.